EUROPE – Margin requirements set for derivatives trades could result in imprecise hedging arrangements, if fund managers were to take measures to counteract the extra costs they would entail, a new report has warned.

In a recent report, Moody's Investor Services argued that new over-the-counter (OTC) derivative margin rules set under the European Market Infrastructure Regulation (EMIR) would increase operational costs for fund managers and would likely prompt them to alter their investment strategies.

According to Soo Shin-Kobberstad, senior analyst at Moody's and author of the report, asset managers overseeing pension fund investments could be similarly impacted as they typically use derivatives for hedging cash flows and hedging long-term real interest-rate risk.

"To hedge the latter, a fund might pair long-dated interest-rate swaps with inflation swaps," Shin-Kobberstad said.

"In this case, the costs related to initial margins could be punitive because the initial margins on the interest-rate swap and inflation swap could be required separately."

This is due to the fact that, to date, central counterparties' (CCPs) infrastructure platforms can only clear products such as interest rate swaps and credit default swaps (CDS) as opposed to inflation swaps, which will continue to trade bilaterally.

Moody's nonetheless conceded that the conclusions made by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) in February this year over requirements for non-cleared trades could provide "significant relief" for smaller fund managers.

BCBS-IOSCO – the two bodies in charge of setting up new guidelines for uncleared derivatives transactions – suggested at the time to apply initial margins for uncleared trades for large transactions only, introducing a €50m threshold.

However, Moody's stressed that initial margin requirements would become standard practice in the future for both cleared and uncleared OTC derivatives and could therefore lead to a drag on investment returns for many funds.

This, in turn, could entail the need for extra staff with the expertise to manage the exposures, thereby increasing a fund's costs, the firm argued.

Moody's went on to say that, to reduce the cost of using OTC derivatives, some funds may therefore choose to use less costly replacements such as standardised OTC derivatives or exchange-traded bond futures instead of customised derivatives that are tailored to their specific needs.

"Whilst lowering costs, these shifts could lead to bond funds holding imperfect hedges or additional credit risks in their portfolios," the report said.